Archive for March, 2012|Monthly archive page

I have a few rich friends who love to complain about money. One of them, Joe, has a $2 million mountainside view. But he’ll swear up and down that he doesn’t know how he’s going to heat his pool, that he’s underwater on his investment properties, and that he’s got cash flow “issues.”

When it comes to taxes, Apple Inc. is like Joe, but with enormous market capitalization.

Unlike most publicly-traded multi-nationals, Apple’s financial statements actually report deferred taxes on its foreign income. Even though generally accepted accounting principles would allow Apple to not book US tax expenses on its foreign profits if they were deemed permanently invested overseas, Apple nevertheless volunteers this expense. This allows Apple to publicly claim a worldwide effective tax rate of 24.2 percent.

Of course, Apple doesn’t actually pay that tax unless it repatriates those foreign profits. Which it doesn’t. Nor does it seem likely to do so in the near future.

On a March 19 conference call with investors, Apple CFO Peter Oppenheimer specifically noted that the potential tax consequences of repatriation deter any such domestic investment. According to him, U.S. tax laws provide a “considerable economic disincentive to U.S. companies that might otherwise repatriate the substantial amount of foreign cash that they have.” (Of course it helps that Apple’s domestic revenues are strong enough to invest in its business, and to fund its recently-announced dividend and share repurchase program.)

So why does Apple elect to report a larger effective tax rate than required? Nobody outside the company really knows. It may be that Apple is simply saving some current profits for future lean times. If it later decides to permanently not repatriate those foreign profits, Apple could then reverse the tax expense and report those past profits in that future period. Or Apple could simply be avoiding the negative publicity other multinationals experience their international tax structuring is scrutinized (*cough* GE *cough*).

What might cause a business to be taxed in a foreign jurisdiction? Control, according to a pair of recent decisions out of Spain and India.

No stranger to aggressive long-arm taxation (see Vodafone litigation), India’s Authority for Advance Rulings (AAR) just issued a February 7 ruling that deemed a French data network provider’s control over certain undersea cables in Indian territory a sufficient presence to justify permanent establishment status in India. The ruling specifically noted that whether the French company owned or leased the equipment was irrelevant, so long as it has the power to control the equipment. Similarly, the AAR further noted that a PE could be triggered by a mere computer or data server in India if a business is conducted through such equipment.

One month earlier, Spain’s Supreme Court teached its long-awaited decision in Roche Vitamins Europe Ltd., ruling that the company’s Spanish subsidiary created a permanent establishment via agency for Roche Vitamins Europe, a Swiss company. Because all of the Spanish company’s activity was directed, organized, and managed by the Swiss company, the Court held that the subsidiary operated as a dependent agent as it carried on, under the two contracts, activities (manufacturing and distribution) that could have been performed directly through a fixed place of business.

The fact that the Spanish sub had no capacity to contract or negotiate for its Swiss parent did not prevent the court from broadly applying the dependent agency clause of the Spain-Switzerland tax treaty. Even though the sub did not “habitually [exercise] authority to conclude contracts that are binding for the” parent (as required by the treaty), the court nonetheless ruled that the parent’s control of the sub was sufficient to attribute to the Spanish PE the profits derived from the sub’s activities (manufacturing and distribution).

These two cases present strong reminders for multinational taxpayers to reexamine structures in which a group member performs, under one or more contracts, activities for nonresident related entities. In particular, taxpayers should determine whether the evidence supports an argument that the local entity has sufficient autonomy and that its operations and/or assets are not subject to a foreign parent’s discretion.

Last week, Haruhiko Kato, daimyo of clan Jas-Dec threatened to unleash an army of samurai warriors against the IRS.

Not really.

But Mr. Haruhiko, head of the Japan Securities Depository Center (JASDEC), did issue a February 28 letter to Commissioner Shulman, urging the Service to promptly issue guidance for the so-called Samurai bond market in the face of the looming expiration of the TEFRA “D” rules:

The repeal of the TEFRA D rules to take effect on March 18, 2012 would halt significant sources of Yen funding for U.S. issuers. As the central securities depository of Japan, we, JASDEC, are extremely concerned about the lack of guidance from the IRS at this point. Accordingly, we would like to request your immediate release of guidance regarding this matter. In anticipation of such potential chaos in the financial markets, recently some major U.S. firms opted to issue Samurai bonds at less-than-satisfactory terms.

What exactly is the esteemed Haruhiko-sama talking about?

A Samurai Bond is a yen-dominated bond issued in Japan, available for purchase by non-Japanese residents.

The Tax Equity and Fiscal Responsibility Act (“TEFRA”) is a law dating back to 1982, meant to prevent U.S. investors from using bearer debt instruments to avoid U.S. taxes. TEFRA imposes sanctions on issuers of bearer debt instruments unless certain measures are adopted to prevent purchases by U.S. investors. To allow the issuance of bearer instruments to bona fide non-US investors, TEFRA does permit issuance outside the U.S. where the issuer undertakes “reasonable arrangements” to prevent such instruments from being sold to United States persons.

TEFRA D is a “safe harbor” measure that allows issuers to be treated as having made such “reasonable arrangements.” U.S. issuers that comply with the TEFRA D safe harbor can therefore issue bearer bonds to non-U.S. investors free of U.S. withholding tax (under the portfolio interest exemption) without the need to collect withholding certificates from each individual investor. The U.S. issuer will also then be entitled to a tax deduction for the interest it pays on such qualified issuance.

Unless prompt action is taken, on that date, the TEFRA D rule will expire, and U.S. borrowers will not be able to treat interest payments as tax-deductible expenses, while investors will have U.S. tax withheld from any interest income.

But that’s only one reason Mr. Haruhiko is concerned. The other is that U.S. issuers are presenting some stiff competition in the run up to the TEFRA D expiration. In the last month, U.S. issuers rush-issued qualifying Samurai Bonds with yields that double those of competing Japanese corporate and government bonds. JP Morgan and Goldman Sachs are just two such issuers looking to borrow before the March 18 deadline.

In the latest salvo, Washington-based Citizens for Tax Justice (“CTJ”) has claimed that GE owed just 2.3 percent in federal taxes on $81.2 billion of pretax profits over the last ten years. According to CTJ Director Robert McIntyre, GE achieves this result by taking advantage of the “active financing” exception to the Tax Code’s subpart F rules, which would otherwise cause GE to owe US tax on its foreign income. McIntyre claims that GE uses this exception to treat offshore financial products as “nowhere income.”

What does all this mean?

Subpart F is an entire, well, subpart of the voluminous US Tax Code meant to impute the income of a foreign business to its US owners. Subpart F’s underlying purpose is to essentially prevent US taxpayers from sheltering income in nominee shell corporations formed in low-tax jurisdictions.

How does this “active financing” exception allow GE out of this regime?

Subpart F income does not include “qualified banking or financing income” of an “eligible” foreign subsidiary. Eligibility is triggered if the foreign sub is “predominantly” engaged in the active conduct of a banking, financing or “similar” business; and the sub is engaged in “substantial” activity with respect to those businesses. . Finally, “substantially” all of the subsidiary’s activities are carried out in its home country or the home country of one of its branches and taxed in one of those countries. GE has presumably established qualifying foreign subsidiaries that meet these elements.

Put simply: if GE owns a bank in Country X, that makes loans to actual Country X residents, and pays rent on its actual Country X storefront, that bank is subject only to Country X taxation. Even if Country X’s tax rate is 5% or 0%.

But let’s look at those requirements again: “substantially,” “predominantly,” “similar,” “substantial” (redux). To a tax lawyer, these words are ripe as a Georgia peach for creative structuring (and billables).

GE isn’t exactly creating “nowhere income,” but the combination of low-tax jurisdictions and the active financing exception’s subjectivity is enough to rankle CTJ.

I’m not suggesting GE is over-aggressive in its Subpart F compliance. In fact, even McIntyre doesn’t come out and point to any particularly questionable foreign finance vehicle. But with that much subjectivity built into the active finance exception, and with banking becoming more mobile and nimble every day, it’s not hard to imagine some serious envelope-pushing.

This possibility for abuse is probably why Congress has never made the active finance exception permanent. Originally, the exception was set to expire in 2002 but was extended to 2006, then to 2009. It was then extended again and again, and is currently, technically, finally . . . . expired. Despite presumed lobbying efforts to the contrary, conventional wisdom assumes that the exception will not be reinstated until after the November elections.

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